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SEBI draft proposals disappointing: IGIDR

Published on Wed, Oct 17, 2007 at 11:32 | Source : CNBC-TV18

Updated at Thu, Oct 18, 2007 at 10:55

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Ajay Shah , Economist at IGIDR says that SEBI's draft proposals on P-notes is disappointing. He adds that it is futile for the government to fully regulate capital flows.

He further adds that he sees a massive churn in markets as the shifting to registered FIIs takes place. The timing of SEBI proposal is unfortunate and on the back of nuke deal issue, he feels.

He also says that the government will not be able to fully control capital flows.

Excerpts from CNBC-TV18's exclusive interview with Ajay Shah:

Q: How have you read the draft?

A: I think that it is a disappointing draft, in that it is trying to put the government in a much deeper involvement in the OTC equity derivatives industry.

Q: And the Finance Ministry has been on record just a few minutes back saying that the SEBI ruling has squarely to do with moderating capital inflows into the country. How do you read that?

A: For some time there has been this claim that there is a problem with participatory notes because of KYC problems. I think today at least there is clarity that that fig leaf is no longer in the picture. The problem that is sort to be addressed is capital controls. And what is needed by the Reserve Bank today is capital controls because they are having a problem running their monetary policy.

Q: Do you think that comes as a bit of a revelation for the market because this whole argument was being couched under that, we do not know our clients, we are unsure of what kind of money is coming in? But the FM gives away the game by saying it is squarely the quantity of money. Is it quite the SEBI's dominion to monitor and moderate capital inflows?

A: Well these are grand questions and all of us have to think about it. The basic point is what is India going to do about capital controls. Do we want to become a modern market economy, do we want to integrate into the world economy, do we want to harness the benefits of globalisation or not?

There is a school of thought which thinks that the good old days were better, the good old days when we did not particularly have capital flows and we were more cutoff from the world. That is the point of debate that all of us face today.

Q: If you are someone who is holding a p-note or is participating through a p-note, what do you takeaway from what has happened in the last 48 hours, because first the call was that look they are targeting derivatives first, it is going to be cash next, and then the Finance Minister comes and says, well p-notes are welcome, but not this much cash right now?

A: There is confusion. The SEBI document of yesterday has many issues in the drafting. So, when I read the document, I also got worried that there is a Thursday expiration coming up on the derivatives. Does it mean that all the hedged positions from the OTC derivatives business cannot be rolled over on Thursday? That would be pretty bad. So, there are many drafting issues.

There is a question of strategy; there is a question of tactics. The question of strategy is, what do you want to do about capital controls? The question of tactics is, do you want to put the offshore OTC equity derivatives business in your concerns.

In my opinion, the offshore OTC equity derivatives industry is performing an extremely healthy and beneficial function. We should welcome that industry; we should try to grow a domestic industry to compete with it. Instead we seem to think that we can put restrictions on that industry. I am sceptical about the extent to which this can be done. It is like an end-user funds monitoring question.

My intuition is like this, when a tonne of steel leaves the country, we do not control whether that steel is used to make ball bearings or not. It is like that. Once we open up to the FII framework, a global securities firm will be able to buy positions in India. Then back-to-back, he will be able to sell derivatives based on those positions, and I believe it is basically futile for India to try to say that, no I am interested in what positions you are holding, which have been enabled by your ability to hedge in India.

So, I think there are some basic questions about what is sought to be done and I think these are important and troublesome questions. So, if there are people in the market, who are worried about what the Government of India is doing, there is merit in that.

Q: Aside from this expiration clarification, what else would you like more details on from the draft policy?

A: It really boils down to this, how will you monitor? Is it even possible to implement all this? Will you get a split between some firms who choose to comply with every detail of what India is doing and some firms who don't?

Even if that is done, there will be a massive churning of positions in the market, as people will switch from one set of firms who provide these products to another set of firms who provide these products. In the short-term that would be extremely disruptive. You have to ask the question, why is it efficient for the Government of India, to throw such disruptions into the normal functioning of markets. Is that the job of a government?

Q: What is your own feeling, how would global investors take this move, people who have been investing through participatory notes, through sub-accounts and even through registered FII channels? Do you think it sends out any kind of a message to them or that is overstating the case?

A: Yes, I think the timing is particularly unfortunate because it follows back-to-back on the difficulties of the nuclear deal. I think the most important thing that India is fighting for is to be seen and accepted in the global community as a sophisticated, modern, trillion dollar, mature market economy. When we do things like this, we are revealing the extent of difficulty in our economic policymaking. Our economic policymaking has not yet figured out, what it is to be a mature market economy.

A: Yes, I think the timing is particularly unfortunate because it follows back to back on the difficulties of the nuclear deal. I think the most important thing that India is fighting for, is to be seen and accepted in the global community as a sophisticated, modern, trillion-dollar, mature market economy. When we do things like this, we are revealing the extent of difficulty in our economic policymaking. Our economic policymaking has not yet figured out, what it is to be a mature market economy.

Q: Now this is open for debate and suggestion as SEBI says if you had to go to the site today and post your top three recommendations and list them in bullet forms, what would those three top recommendations be?

A: My biggest recommendation would be that one needs to understand the business in its entirety. I don't think that there is a clear understanding of the business model of the offshore OTC equity derivatives business yet. The way it works is like this.

There is a bunch of global securities firms who sell OTC equity derivatives on Indian underlines to anybody and everybody who wants them. This is healthy and this is legitimate. Then these people who are running a book figure out what is their overall exposure to India and they come back-to-back to India and they lay off that exposure using the exchange rated derivatives. This is healthy and this is legitimate.

I just don't share the comparisons that are being made in the document. There is sense that if there is an OTC derivative outside. But back-to-back it is hedged by using an exchange-traded derivative in India that is somehow bad. It's not correct. That is how OTC derivatives work. That is how OTC derivatives should work. That the OTC derivative does customization and back-to-back the risk is laid off on the exchange traded derivative. There is a comparison between the size of the notional value of the OTC derivatives and the size of the spot investments in India.

But these are completely non-comparable. The notional positions on derivatives will always have very big numbers. There will be some longs. There will be some shorts. There will be a lot of canceling out. One doesn't take those numbers so seriously and it's wrong to juxtapose them against the size of a spot position in India. There are some severe conceptual confusions about the offshore OTC equity derivatives business and actually maybe we are flogging a dead horse because we know more transparently that really what is going on is this is a game of capital controls. It has nothing to do with participatory notes. It has nothing to do with equity derivatives. It's a capital control story. The deeper thing you have to go after is, why is that there is this passion for capital controls today?

Q: We are also just trying to understand how easy the process is for someone whose been investing through a P-note to now switch to some other route to bring their cash in and how easy it is to register as an FII in India? Any thought on both those counts?

A: If the top 10 venders who are currently producing OTC equity derivatives on Indian underlines are basically put out of business, then for sometime, it will be quite a disruption. Gradually people will find other vendors and other producers who will sell the same products. Intuitively you are saying to me that - this big firm buys steel in India, makes ball bearings and sells them, but now this firm is blocked. Okay fine, after a short time there will be another set of firms who will produce the same goods.

The second thing is that people who have been trying to avoid the frictions and the transactions cost of setting up an official FII registration in India will now take the trouble of doing an FII registration in India. Again these are not things where government of India should be trying to shape the direction of this industry. If anything, we should be asking why is there an FII registration framework in the first place? Most countries in the world don't have a concept on an FII. The equity market is wide open. The foreigner comes and directly holds a depositary account. He would hold shares with NSDL and CDSL directly. You don't need to put all these middlemen in the picture who are just earning money and making intermediation costs higher for the end user of these products.

Q: Just get back to that capital controls point. The assumption here seems to be that once you take away P-notes and force FIIs to register, capital flows will moderate automatically. Is that a little na�ve for a market which is seeing such a lot of interest amongst global participants and which lots of people are not exposed to today? Do you think it may surprise the finance ministry that going forward w may see capital flows which are even larger despite controls than what we have seen in the past?

A: There is too much going on the capital account and these controls don't get the job done. I would like to remind everybody about a few months ago when there was a campaign to put restrictions in external commercial borrowings, ECB. At that time that was proposed as a great solution to the problem of the monetary policy regime. Did it work? No, it did not work.

So we need to more skeptical about the kind of analysis that is going below these things.

Q: Do you think the government is simply panicking on the rupee?

A: There is a very loud constituency that says that the old monetary policy framework of India is the one that should continue to be used. Now, unfortunately, that old monetary policy framework was devised in a closed economy. It worked in the India of the '80s; it worked in the India of the early '90s. By the late 1990s, the old monetary policy framework was in a lot of trouble, because India's globalisation and openness, inherently involves contradictions against that old monetary policy framework. Now, when you have a contradiction between India's progress and an old monetary policy framework, what do you do?

To me, the answer is you reform the monetary policy framework. So, far what the government has been doing is they have been protecting the monetary policy framework, and so the focus has been can you get capital controls - can you force India back into an old system? Can you force India to go back to a world of capital controls, so that the old monetary policy framework can continue to work? I disagree. I think that we have to look forward; we cannot look backwards. It is not sensible; it is not useful for us to try to force India back into an early '90s framework.

Q: I was just reading your piece in the morning; I don't know if it was a reaction to what's been announced overnight but the FM also today said that this is part of a series of steps to control capital inflows are you saying that its more or less a given the next salvo would be fired by the RBI and will be in this direction as well, capital control?

A: I have no knowledge of the decision making process. But I'm just watching the messages coming out of RBI and yes there is a campaign to have more capital control, that is the direction that the Reserve bank wants.

Q: Does it also send a message that our regulatory bodies are actually extensions of the Central Government and they are not as autonomous as we would like to believe?

A: Yes, it does raise questions about the technical soundness of securities regulation in India.

Q: What do you reckon is going to happen with these capital inflows, because we have been talking about it, and yes it has been stunning over the past month or six weeks, the biggest dollop has come in, in this insulated period? Do you see any significant slowdown in the next 6-8 months or 12 months?

A: Conditions could possibly change dramatically. Do not underestimate the difficulties that are being faced in the world economy today. There are really big problems with the gigantic Chinese reserves accumulation, with the investment bubble in China, with the difficulties in the US economy. Global economic conditions could deteriorate quite dramatically; there could be a flight to safety.

I am not here to say capital flows are going to be here day-in and day-out. But I am here to say that there is all said and done, there are important benefits for India from globalisation. There are important benefits for India from integration with the global economy. That it is no longer possible for India to turn its back away from the capital account openness, which we have already got. And that, if there is a conflict between India's progress and the monetary policy regime, then I think it is better that the monetary policy regime should adjust.

Q: Do you think people globally may frown at the fact that the government is actually stepping in to take calls on when it considers particular markets excessive or overvalued or overheated and injecting policy action to cool markets down, even markets that are not currency related?

A: I do not think it is about markets being overheated. I think it is about capital controls. That is the story going on right now, it is about the running rupee-dollar pegged exchange rate, it is about the monetary policy regime, it is about capital controls. Everything else is small change compared to that.

Q: In your estimation does this usually work though, when you do put in these kinds of controls in whatever forms like you said? Does it really temper the gains of the rupee because to be fair to the dollar its been weakening against most everything not just the rupee?

A: My sense is India is at a point where it is no longer possible to turn the clock back. All through the 1990s, all the way till 2000-01, you could have still turned the clock back. You could have brought back draconian regulations, you could have brought back draconian capital controls and you could have got away with it.

Today the genie is out of the bottle. India has come to far along. India has a fairly high amount of openness on the capital account. Enough big holes have been punched in the system of capital controls. You try to prevent money from coming in from one hole; the money will come from other holes. Also remember that every time you introduce a new capital control you are making somebody's life bad. You're making somebody unhappy. There is a political cost to capital controls that when you block some people from doing ECB, you are making somebody unhappy.

You are increasing the cost of business for somebody. When you block P-notes, you are increasing the cost for somebody. You are increasing somebody's unhappiness. There are real cost to these things. Every equity investor in India this morning is irritated at the volatility of the equity market at the fluctuations of the equity market. These things filter through the political system. These mistakes of economic policy, this fumbling of economic policy has real consequences and that filters through the political system.

My expectation is that India today is open enough that you cant bring back the capital controls. You could have done that in the 50s. You could have done that all the way till the 90s. There was a meek and helpless country, which should pretty much accept what a government wanted to impose, but the world has changed. India is now much more open much more modern. There is a much better understanding of how these things work. There are numerous avenues to move money across the boundary. If all else fails people will do transfer pricing through the trade account. People will move capital across the boundary and the government is not in control. So my understanding is that this will not work. You will not be able to make a substantial difference to the capital flows moving across the boundary. All that we are able to do is, we are able to send out an image. We are able to send out a message to the global community that India is not a mature market economy.